09 April 2009

Storage Risk

Tom Szabo of silveraxis.com has followed up on my post yesterday with some further detailed comments and a new category - Pool Allocated. he is right to split my Segregated Allocated into Allocated and Pool Allocated, as this can be important in some countries as to whether the "foreign account" is reportable to tax authorities. I interpret what Tom is saying as essential that in both the gold is physically put aside in a vault and title is with the holders (ie it is not on the balance sheet of the custodian), the difference being in whether this gold is then further separated by client.

I think it be best be thought of with the example of a person A buying 10 x 1oz coins and 10 x 10oz bars and person B buying 5 x 10z coins, both of them storing with the same custodian. In Tom's "Allocated", the custodian puts person A's coins and bars together in a pile/box with their name of it and then a separate pile/box for person B's coins.

In "Pool Allocated", the custodian has a pile of 15 x 1oz coins and a spearate pile of 10 x 10oz bars and has a ledger indicating that person A has 10 of the 15 coins and person B owns the remaining 5 and that all of the 10 bars belong to person A. As Tom points out, this can only be done with products that are the same, and not with 400oz bars or 1000oz bars, or indeed with 1oz legal tenders coins as they have different years on them (but can be done withing each year, to further confuse).

Most will see little difference between the two, as the key thing is that everything is 1:1 backed and not in the assets of the custodian. As Tom notes, Pool Allocated is more operationally efficient so should have lower costs (there is no difference in insurance cost for the custodian). It can matter, however, in how some tax laws define a reportable account. Some may be very specific that any "mixing" as in Pool Allocated makes it an account. Other may simply require the physical and title separation from the custodian's other business (if any).

With this further categorisation clarification, Tom also asks what the Perth Mint's "Allocated" is? For the most part it is Pool Allocated. I should point out that in respect of our legal tender coins, the segregation is by year. This means that if you buy 10 coins in 2005 and 10 in 2007, we have those years in storage because we make the coin in that year and put it in the allocated vault. Once put in, it stays there. But it is pooled in that if there are 10 clients with 10 2005 coins each, there is a pile of 100 2005 coins.

It gets a bit messy with numbered bars and the LBMA bars, because Tom says that "pool allocated accounts aren’t possible with good delivery bars". When you buy a numbered bar (whether consistent ounces like kilo bars or odd weight like LBMA bars), we put that specific numbered bar into the vault and allocate that number to you. But again, for practical storage purposes, the numbered bars are stored together. For example we will have a 1 tonne pallet of 80 x 400oz bars of varying weights, but even though they are together, if you pulled a specific bar out we know exactly who owns it.

Once we've worked all these variations out, maybe we need some agreed industry storage taxonomy so investors know exactly what they are getting. Marketing can sometimes get in the way of strict legal definition.

12 comments:

So I get the impression that Tom sees very little fundamental difference between ETF's like GLD and systems like BullionVault with respect to storage type (i.e. they are both pooled allocated with GLD investers and BV account owners having a claim on the pooled physical assets). I'm commenting here because his comments are closed and you might have some insight.I have come to understand that even though GLD may have a certain amount of physical gold in it's custodian's vaults, GLD shares can be sold short. This means a shareholder's claim to the GLD trust can be diluted under their nose (i.e. more GLD shares can be outstanding than what would be indicated by the vault contents and the 1/10th share to metal ratio). It doesn't seem like this can be the case with BullionVault. What do you think?

I can't speak for Tom, but I see a big difference between GLD and BullionVault/Gold Money or indeed Perth Mint Allocated. I am not comfortable with the many counterparties involved in GLD - more people, more opportunity to blame someone else. The others have less "messy" structures.

You do have a point about short selling of shares and are correct that this is effectively fractionalised gold. It depends on the exhange (eg Perth Mint's ZAUWBA is not short sellable), but from what I know, GLD is potentially suspect because of the way the US system works.

Further to my comment, after going through this presentation - http://www.24hgold.com/english/news-gold-silver-how-wall-street-cheats-the-individual-investor.aspx?article=1383108022G10020&redirect=false&contributor=How+they+do+it - I wouldn't buy any gold ETF listed on an American exchange.

Thanks for the link to the animated slide presentation. Very informative. So one more question regarding pool allocated accounts like Bullion Vault. Their daily audits prove the amount of gold in the vaults equals the total of the individual amounts next to each alias in their public account holders list. You as an individual know your own alias but not anyone elses. If you don't have a multiple of a 400oz bar reserved in your name, it is not quite clear that this proves the proper amount of gold is physically allocated to you. What is to prevent BV from creating a second set of account allocations unseen by the public or auditor, whose totals match the amount of gold in the vaults? They could sweep some gold from your account into theirs for trading an profiting from and then put it back when they get finished. This could all be done with the totals of this fraudulant account allocation still equaling the total metal in the vaults. You as an investor only see the allocation list they want you to see and it is not clear that an auditor would be able to discover this fraud. I'm not saying this is happening but I am trying to see how much risk is actually being reduced with their daily audit system. How comforted can I be by it? In other words if x+y+z=T and all I can verify is the total T, how do I know I really have x amount of gold in my account other than some paper statement that says I have x? There can exist many fraudulant combinations of x, y and z that equal T. Because this market exists in their mainframes, only they know exactly how the gold in the vault is really allocated. Of course as I think about it how do I know from any paper statement that I really have the amount that is shown? Am I thinking about this incorrectly?

I haven't fully investigated the Bullion Vault system but I would consider it and Gold Money to be two of the most safest systems out there (everything has risks of course), along with Perth Mint.

I was quite impressed by the concept of their daily audit system. I can't think of a better way to give confidence to account holders that the electronic balances are backed by physical at all times apart from actually inviting them to do the audit themselves.

OK, so we have x+y+z=T and we have independent confirmation of T. If they are not fully backed, then x+y+z would be less than T. For this to happen it means there is a client w who is not listed.

The system works on the basis that account holders will check their electronic balance as reported in the daily audit to ensure that it matches the balance they expect as a result of their transactions. Bullion Vault can't misreport x, y or z, or miss w out, otherwise they will "blow the whistle" and publically report that Bullion Vault's list is wrong.

The catch is ALL holders have to do the check, if people don't check, the maybe Bullion Vault could report slightly less balances for holders or miss holder outs so that the summation would equal their (short) T. But if you put yourselve in the shoes of Bullion Vault, this is playing with fire because you don't know which account holder does or doesn't check their balance, and if you pick the wrong account (and you would need to pick a lot of accounts, no benefit from only being a few ounces short), your whole business integrity is shot and you are out of business.

This is why I think it is as robust a control system you can get and would probably put Bullion Vault ahead of Gold Money for me.

Anyway those are the positives. There are still risks - nothing stopping any custodian from simply stealing the metal. That applies to any facility, including Perth Mint (ie Government confiscation). Ultimately it comes down to trusting the custodian.

Thanks again for the clarification. But allow me to pursue just a bit further. I think you are right in that fraud can be discovered at the daily audit time due to the public lists and independently verified totals, but what about in between? So given x+y+z=T. If z is an account used for fraud by somebody inside BV, then in between audits, z can sell electronically created gold to x as long as he buys the same amount back from y before the next daily audit. This is like naked short selling with a fixed time period of one day to cover. Is it possible for z to do this in such a way that he is guaranteed to be able to drive the price down within 24hrs so that when he buys back to cover he makes a profit? So if this is possible is it relevant? I

What you proposed could be done, but I don't think there would be enough volume to move the price. Certainly Bullion Vault could short sell within its system, but this would just mean that the gold price in its system would diverge from the spot prices for gold being quoted by others (eg GLD, GoldMoney, Perth Mint, Kitco).

The effect of this would just be to give the impression that the Bullion Vault price is not liquid and does not match the real gold price, resulting in few people wanting to use the system.

Thanks again for providing your thoughts. What you wrote helps my understanding alot. As I compare BV and GLD I definitely like what the BV daily audit and account owner list provide. When I look purely at the storage reporting for both I see very little difference. GLD's storage provider, HBC, provides daily bar lists. BV's storage provider, VIA MAT, provides daily bar lists. HBC's count(audit?) is conducted by Inspectorate International Limited. Who conducts VIA MAT's bar count (audit)? Do you have any insight on how these bar count/audits are actually conducted (i.e. method and frequency)? Do you have any opinion on the integrity of VIA MAT vs HBC? Who handles Perth Mint's bar count/audits?

I haven't investigated BV's auditing process or frequency, but VIA MAT has been in the storage and distribution business for many years and is used by many in the precious metal game, including Perth Mint. They are a legitimate business and no less or more integrity than HSBC or any other physical custodian.

We do our own bar counts/stocktakes quarterly, with finanical year end ones overseen by our external auditors, who are actually appointed by the Auditor General of Western Australia and not by us. They are therefore more independent than most external auditors, who are appointed/paid by the business itself.

Hi Bron,Back again. I have done a bit more research on the BV and Via Mat audit process. After much reading it seems the storage provider matters. I have read that while HSBC stores GLD gold it also is a bank and has a large gold short position on the COMEX. I have read people speculate that if they get squeezed they will illegally use the GLD allocated gold in their vaults to cover and just pay whatever fines as a result. Not quite sure how that would work but do you have any thoughts on the matter?

Finally it would seem that having a storage provider who also was a bank and had other business objectives besides just storing your metal, would be an increased risk. do you agree?

My understanding is that Via Mat is only a storage company and would have no motivation to short sell your gold. Is this right?

Would you agree that Perth Mint is not purely a storage provider so that their other gold business activities could potentially increase risks of someone who had their gold stored there?

Strictly speaking the other activities of the storage provider should not matter. The contractual obligation of custodianship should be segregated from the other activities of the business.

To raid custodial metal (similar to accessing funds in a trust account) is a big step and in a large organisation unlikely to happen in my opinion because you would have to involve so many staff on the custodial side and get them all to shut up about what is an obvious fraud. Staff on the custodial side of the business will know that if they do not say anything, they are likely to be deemed criminally complicit with the fraud when the police come around. I just can't see every single vault and office staff being prepared to take on that liability.

Consider a bank short gold. Their options as you present are either take a loss on being squeezed or raid allocated metal but then incur a loss on that. Either way they are going to have a loss, so why use the allocated metal? You may be able to hold off the bankruptcy, but you will never be able to replace the bars, number for number, so will get busted anyway.

Best to take the loss on the short position and at least still have a custodial business that is operating.

Your question is really about assessing the risk that the business you are storing with is likely to experience financial stress of a nature that "temporarily" selling allocated metal might get them over it.

From that perspective whether the storer is a bank or storage only business is probably not really a factor. I would say the size of the operation is more of a risk factor on the basis that a small or new business is more likely to be stressed from a cash flow point of view.

Certainly a bank with who knows what exposures on its balance sheet may be a risk. But storage only business only has one revenue source so could also be at risk if that revenue drops below fixed costs.

Whether HSBC and Via Mat are equal on this factors I can't say as I haven't analysed their balance sheets and profit and loss.

For the Perth Mint, we don't engage in speculative trading - we aren't a bank. Our "other gold business activities" are just making coins and bars and refining. Have a look at our annual report note 26 financial instruments and you won't see any massive numbers there.

Also, unlikely private or listed companies, we don't have problems sourcing cash funding - we can always borrow from the Government. The only way management would therefore consider accessing allocated metal is if it had illegally undertaken some speculative trades. That scenario itself is difficult for me to imagine given the segregation of duties we have in place, but then to try and cover that up by selling allocated metal - just too many average wage staff involved for them to keep quiet about it.

My personal blog on all things precious metals. This blog is not endorsed by the Perth Mint (who I work for) in any way. For more background on me and this blog see About This Blog and my LinkedIn Profile. Twitter account @bronsuchecki

See the Perth Mint's Research section for my official work (currently building the content for that site).